Methods of Repurchasing Stock

Methods of Repurchasing Stock

A corporation may repurchase its own stock by any of three methods: (1) a tender offer, (2) open market purchases, and (3) a targeted share repurchase.

Tender Offer

A tender offer is an offer made to all shareholders, with a specified deadline and a specified number of shares the corporation is willing to buy back. The tender offer may be a fixed price offer, where the corporation specifies the price it is willing to pay and solicits pur- chases of shares of stock at that price. For example, The Limited Inc. made a repurchase tender offer in early 1996, offering to buy up to 85 million of its shares for $19 a share at a time when its shares were trad- ing for $16.50 a share.

18 The phrase “dividend puzzle” originates from Fischer Black, “The Dividend Puz- zle,” Journal of Portfolio Management (Winter 1976), pp. 5–8.

FINANCING DECISIONS

The tender offer may also be conducted as a Dutch auction in which the corporation specifies a minimum and a maximum price, soliciting bids from shareholders for any price within this range at which they are willing to sell their shares. After the corporation receives these bids, they pay all tendering shareholders the maximum price sufficient to buy back the number of shares they want. A Dutch auction reduces the chance that the firm pays a price higher than needed to acquire the shares.

To illustrate how a Dutch auction works, suppose a corporation wants to buy back 1 million shares of common stock currently trading for $25 a share. If the firm make a tender offer for the shares, it must specify the price it is willing to pay. The price must be higher than $25, or no one will be willing to sell back the shares. Because it is sometimes difficult to figure out just how much more to offer, the firm can use a Dutch auction. A Dutch auction sets the buying price for the item on the basis of bids.

For example, the firm could make a Dutch auction tender offer, specifying that it wants to buy back 1,000,000 shares, offering to buy at

a minimum price of $26 and a maximum price of $29. Shareholders who want to tender their shares—sell them back to the corporation— specify how many shares they are willing to sell and at what price. Sup- pose the shareholders respond as follows:

Number of Shares Willing to Tender

Specified Price

The corporation will accept the first 1,000,000 shares in order of price, paying only one price and not higher than necessary to get that 1,000,000 shares. In this example, the corporation would pay $28 per share of the 1,000,000 shares. The shareholders that specified they would tender their shares at $29 per share are out of luck. The share- holders who bid $26 and $27 are paid more than the price at which they were willing to tender.

Open Market Purchases

A corporation may also buy back shares directly in the open market. This involves buying the shares through a broker. A corporation that wants to buy shares may have to spread its purchases over time so as not to drive the share’s price up temporarily by buying large numbers of shares.

Common Stock

Targeted Share Repurchase The third method of repurchasing stock is to buy it from a specific shareholder. This involves direct negotiation between the corporation and the shareholder. This method is referred to as a targeted block repurchase, since there is a specific shareholder (the “target”) and there are a larger number of shares (a “block) to be pur- chased at one time. Targeted block repurchases, also referred to as greenmail, were used in the 1980s to fight takeovers.

Reasons for Repurchasing Stock Corporations repurchase their stock for a number of reasons. First, a

repurchase is a way to distribute cash to shareholders at a lower cost to both the firm and the shareholders than dividends. If capital gains are taxed at rates lower than ordinary income, which is often the case with U.S. tax law, repurchasing is a lower cost way of distributing cash. How- ever, since shareholders have different tax rates—especially when com- paring corporate shareholders with individual shareholders—the benefit is mixed. Why? Because some shareholders are tax-free (e.g., pension funds), some shareholders are only taxed on a portion of dividends (e.g., corporations receiving dividends from other corporations), and some shareholders are taxed on the full amount of dividends (e.g., individual taxpayers).

Another reason to repurchase stock is to increase earnings per share. A firm that repurchases its shares increases its earnings per share simply because there are fewer shares outstanding after the repurchase. But there are two problems with this motive:

1. Cash is paid to the shareholders, so less cash is available for the corpo- ration to reinvest in profitable projects.

2. Because there are fewer shares, the earnings pie is sliced in fewer pieces, resulting in higher earnings per share. The individual “slices” are big- ger, but the pie itself remains the same size.

Looking at how share prices respond to gimmicks that manipulate earnings, we know that you cannot fool the market by playing an earn- ings per share game. The market can see through the earnings per share to what is really happening and that is that the firm will has less cash to invest.

Still another reason for stock repurchase is that it could tilt the debt-equity ratio so as to increase the value of the firm. By buying back stock—thereby reducing equity—the firm’s assets are financed to a greater degree by debt. Does this seems wrong? It’s not. To see this, sup- pose a corporation has the following balance sheet:

FINANCING DECISIONS

Assets $100 Debt $50 Equity $50

The corporation has financed 50% of its assets with debt, and 50% with equity. If this corporation uses $20 of its assets to buy back stock worth $20, its balance sheet will be:

Assets $80 Debt $50 Equity $30

It now finances 62.5% of its assets with debt and 37.5% with equity. If financing the firm with more debt is good—that is, the benefits from deducting interest on debt outweigh the cost of increasing the risk of bankruptcy—repurchasing stock may increase the value of the firm. But there is the flip-side to this argument: Financing the firm with more debt may be bad if the risk of financial distress—difficulty paying legal obligations—outweighs the benefits from tax deductibility of interest. So, repurchasing shares from this perspective would have to be judged on a case-by-case basis to determine if it’s beneficial or detrimental.

One more reason for a stock repurchase is that it reduces total divi- dend payments—without seeming to. If you cut down on the number of shares outstanding, you can still pay the same amount of dividends per share, but your total dividend payments are reduced. Suppose you pay a regular, quarterly dividend of $2.00 per share. If there are 1,000,000 shares of stock outstanding, your quarterly dividend payment is $2,000,000. If you repurchase 10% of the outstanding shares and keep the dividends per share the same, your total quarterly dividend payment is $2.00 times 900,000 shares, or $1,800,000. You have reduced your payment by $200,000, yet have not changed the dividends per share.

If the shares are correctly valued in the market (there is no reason to believe otherwise), the payment for the repurchased shares equals the reduction in the value of the firm—and the remaining shares are worth the same as they were before. In our example, the repurchase reduces the equity pie by 10%—and the smaller pie comprises 10% fewer shares. Suppose the shares traded at $50 per share before the repur- chase—total equity is $50 times 1,000,000, or $50,000,000. If the firm buys back 10% of the shares—100,000 shares at $50 each—the value of the firm should decline by $5,000,000. This leaves equity worth $45,000,000. Split among the remaining 900,000 shares, the value per share is $50—the same as before the repurchase.

Some argue that a repurchase is a signal about future prospects. That is, by buying back the shares, the management is communicating to investors that the firm is generating sufficient cash to be able to buy

Common Stock

back shares. But does this make sense? Not really. If the firm has profit- able investment opportunities, the cash could be used to finance these investments, instead of paying it out to the shareholders.

A stock repurchase may also reduce agency costs by reducing the amount of cash the management has on hand. Similar to the argument we used for dividend payments, repurchasing shares reduces the amount of free cash flow and, hence, reduces the possibility that management will invest it unprofitably.

Repurchasing shares of a firm tends to shrink the firm: Cash is paid out and the value of the firm is smaller. Can repurchasing shares be con- sistent with wealth maximization? Yes.

If the best use of funds is to pay them out to shareholders, repurchas- ing shares maximizes shareholders’ wealth. If the firm has no profitable investment opportunities, it is better for a firm to shrink by paying funds to the shareholders than to shrink by investing in lousy investments.

So how does the market react to a firm’s intention to repurchase shares? A number of studies have looked at how the market reacts to such announcements. In general, the share price goes up when a firm announces it is going to repurchase its own shares.

It is difficult to identify the reason the market reacts favorably to such announcements since so many other things are happening at the same time. By piecing bits of evidence together, however, we see that it is likely that investors view the announcement of a repurchase as good news—a signal of good things to come.